Mortgage Bank Hedging 101. CitiMortgage Layoffs. Thornburg Sues Goldman.

Below are two notable items on this slow news day, as well as a primer on how mortgage banks lock loans and hedge risk.

(1) The bankruptcy trustee for Thornburg Mortgage sued Goldman, Barclays and other big banks for a combined $2.2 billion, blaming them for its bankruptcy. Meanwhile, former Thornburg CEO Larry Goldstone is rebuilding a new mortgage machine.

(2) CitiMortgage (Fourth-ranked lender in 4Q2010 with a 4% market share) announced it is laying off 400 employees who work in its loan sales and fulfillment operations in five cities (O’Fallon, Dallas, San Antonio, Ann Arbor, Mich., and Las Vegas) due to declining demand for mortgages.

Mortgage Bank Hedging 101
Mortgage banks fund and close loans, then sell them to investors (and sometimes retain the servicing to they can be point of contact with their borrowers). When a loan agent locks a loan with an investor on a “best-efforts” basis, and the loan funds, they deliver it (one assumes). If the loan doesn’t close, they have nothing to deliver, and there is no penalty (within certain limits). When a loan agent locks a loan with an investor on a “mandatory” basis, and it funds, the originator delivers it, and when it doesn’t fund, the originator is “on the hook” to the investor and owes a penalty. Of course, both parties attempt to negotiate penalties, trying to stay away from talk of “broken thumbs” and “first born children,” but those are the basics.

When a company hedging their origination pipeline by selling mortgage-backed securities buys an MBS back (pair off), either it owes the dealer money, or visa versa, and this money changes hands on settlement day. But what if they, uh, just don’t? The Treasury Market Practices Group, which the Federal Reserve Bank of New York helped form in 2007 to offer advice on debt markets, proposed “fail” charges similar to those for U.S. government bonds. Dealers and investors that fail to complete trades in agency debt and mortgage bonds may pay as much as 3% in penalties.

Interestingly, near-zero overnight rates have encouraged failures by reducing the cost of uncompleted trades, while at the same time the Fed’s purchase of $1.25 trillion of mortgage bonds through March 2010 made it more difficult to find bonds to settle contracts in a timely manner.

The press released noted, “Uncompleted trades in agency mortgage securities remain elevated after rising to a record of almost $2.4 trillion during a week in November, according to Fed data. Failures to receive or deliver the securities, which totaled $1.5 trillion in the week ended April 20, averaged about $330 billion weekly over the past 10 years.”

Not so fast, say some investors including PIMCO, who say 3% will reduce intentional fails but sharply reduce liquidity and incent accounts to attempt short squeezes – 1% is better. Do I hear 2%? Public comments are due by 6/10, with any changes expected in 2012. At this point dealers are not expecting much impact, as some kind of charge is anticipated by the market.